Absorption costing requires the inclusion of all manufacturing costs, direct and indirect, into units of production. Direct manufacturing costs, such as direct labor and direct materials, can be traced directly to units of production. Indirect manufacturing costs, on the other hand, are incurred to support production but are either difficult or impossible to trace to individual units of production. For this reason, about the only way to assign overhead costs to units of production is by allocating them based on a reasonable allocation base.
Add up the total manufacturing overhead costs. This can be obtained from the company's financial records. Manufacturing overhead includes many different costs. Some costs will vary with production, while others are fixed. Manufacturing overhead includes everything from the cleaner used on the shop floor to depreciation of the lighting fixtures attached to the ceiling.
Choose an allocation base. An allocation base is a measure of activity that is used to assign overhead costs to products. Manufacturing overhead costs are divided by the allocation base to determine the amount of manufacturing overhead that should be assigned to each unit of production. Two common allocation bases used in manufacturing are direct labor hours and machine hours.
Review payroll or maintenance records to determine the total of the allocation base generated in the current period. For example, the company's payroll records may reflect that 2,000 direct labor hours were worked during the current period.
Divide the total allocation base value by the number of units produced to determine the amount of manufacturing overhead attached to each unit of the allocation base. For instance, if the company has $10,000 in overhead and 1,000 direct-labor hours, each direct labor hour will have $10 ($10,000 / 1,000) of overhead attached to it.
Monitor production to determine the quantity of the allocation base that is to be assigned to each unit of production. For instance, the analysis may reveal that product A requires one labor hour to produce, while product B requires two labor hours.
- Financial records
- Production records
- Payroll records
- Be sure to choose an allocation base that directly correlates with increases in manufacturing overhead costs. For example, when manufacturing equipment is kept running for an extra shift, the electric bill increases. This is an example of how machine hours drive electricity costs.
- Direct labor hours are the most popular allocation base, but it may not always be the most appropriate, particularly in highly automated manufacturing environments.
- "Managerial Accounting"; Ray H. Garrison, et al; 1997
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